Magazine

Housing: That Sinking Feeling

October 14, 2007

By Mara Der Hovanesian and Christopher Palmeri COVER STORY PODCAST

Las Vegas was once the hottest of the red-hot real estate markets. But when sales really started choking up last year, developer KB Home (KBH) did something drastic. Determined not to be caught with a big backlog of unsold homes through one of the industry's notorious down cycles, the builder started slashing prices. A lot. In the 1,400-home Huntington community, a subdivision of two-story stucco houses west of the famed Strip, homes that started at $320,000 a year ago are now listed for $270,000--just a starting point for potential deals.

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Those sorts of discounts seem to be attracting buyers. Pending sales contracts jumped 23% after KB cut list prices by $25,000 in May, one of the recent price breaks in the Huntington subdivision, according to the market research firm Hanley Wood. That may be good for KB, or at least less bad than holding on to a lot of unsold units. It may also be good for current buyers who snap up homes at huge discounts to recent asking prices. "We try to make prudent decisions regarding pricing," says Jim Widner, regional general manager for KB in Las Vegas. "Prices are going to rise and fall over the short term, but long term a home is one of the best investments."

For homeowners who jumped in at the height of the boom, the discounts aren't so good. In Quayside Court, a quiet cul-de-sac in Huntington, many residents who bought last year suddenly own homes worth a whole lot less--making it hard for anyone who has to refinance, sell, or borrow against the equity. "When we first moved here [in the summer of 2006], the housing market was incredible," says Tammy Elder, a mother of three. "Unfortunately we bought a house that was overpriced, and we don't know if we'll ever break even."

KB's extreme strategy at Huntington is playing out across the country--even in places like Minneapolis and St. Louis that were bypassed by housing mania. For the first time, big builders are offering massive, often six-figure, price cuts in overbuilt developments nationwide, giving the industry a kind of shock treatment designed to move inventory off the books fast. It remains to be seen whether these radical measures will revive the market or deepen the slump, but it's certainly having an impact on the local communities. On Sept. 14, Hovnanian Enterprises Inc. (HOV) kicked off a 72-hour Deal of the Century, in which it slashed prices by as much as $100,000 in 19 states. That same day, Standard Pacific Corp. (SPF) launched its Mission: Possible campaign in 49 communities across Southern California, promising $20 million in total discounts. And on Sept. 29, D.R. Horton Inc. (DHI) auctioned off 53 homes in San Diego with bids starting at $150,000, half off the list price. "We wanted to get the message across louder," says Hovnanian CEO Ara K. Hovnanian. "Customers needed a stimulus."

UP-FRONT PAIN

Builders' balance sheets needed a boost, too. Even though the five-largest publicly held residential builders have cut the value of their land and unsold homes from $49.7 billion in 2006 to $41.9 billion today, that inventory as a percentage of sales has soared 33% during the past year, according to Banc of America Securities (BAC). Those idle assets have taken a toll on the industry's health. A year ago builders' debt payments were roughly the same as their cash flow. Now debt is 2.5 times cash flow. Profits are disappearing as well, with KB Home, D.R. Horton, and other big builders all reporting losses in the third quarter. On Sept. 25 the country's No. 2 builder by homes sold last year, Lennar Corp. (LEN), reported a $513.9 million quarterly loss, the biggest in its 53-year history. And while there have certainly been other influences on the market, builders bear a lot of the blame for their woes.

The real question is whether the drastic price-cutting will short-circuit the usual long, painful downturn builders seem destined to undergo in this economically sensitive business. This is the first housing slump in which the industry has been big enough and well enough capitalized to even consider such extreme measures. And they are extreme. Margins, which ran as high as 35% at the peak of the housing boom, are close to nil when builders sell at fire-sale prices. If by doing so the builders can force the market to accept the reality that housing values have fallen--and accept it fast--there's at least the possibility of emerging from the current bust sooner than in earlier down cycles. "The discounts depress the market, and that's why we think home prices have got more to fall," says David Wyss, chief economist for Standard & Poor's, which like BusinessWeek is owned by The McGraw-Hill Cos. (MHP) "But rather than a prolonged bust, you take the pain up front." A fast recovery in the housing market wouldn't just be a tonic for builders; it could also give a much needed boost to the overall economy.

There is, of course, much that could go wrong. Indeed, potential risks with this untested strategy abound, especially for smaller players. If the price cuts aren't deep enough or builders don't rein in production enough, they won't clear out the glut of unsold homes. Then there's the worry that the discounts lower prices too much, forcing builders to write down even more of the raw land held on their books. And if prices keep falling, buyers could decide to cancel contracts in hopes of getting a better deal later, as they've already started to do. There are also broader markets forces at play, ones that builders may not be able to surmount even by slashing prices. For example, the rising number of foreclosures could add to the backlog of unsold homes faster than they can clear them out. "It's a losing battle," says Jim Belfiore, president of Belfiore Real Estate Consulting, a research firm.

Still, builders figure they're better off cutting supply fast rather than letting it drag down earnings for months or even years. "You have to keep moving inventory," says John F. Eilermann, Jr., chief executive officer of McBride & Son Homes, a privately held regional firm that's offering discounts of up to $100,000 and hosting block parties with pig roasts to lure buyers in St. Louis. "Our biggest cost is the land sitting out there. You have to get yourself in a better position for when the market does turn."

PSYCHOLOGICAL BLOW

Following its deal of the century, Hovnanian, the nation's No. 7 builder, booked more than 2,100 gross sales with 1,700 contracts and 400 sales deposits. Standard Pacific has 227 pending contracts from its sale. Assuming those and other such deals ultimately close, the homebuilders could recoup some of the capital tied up in their unsold properties and generate enough cash flow to keep up with their debt payments. That's paramount for builders' survival. "They're better off clearing the showrooms than sitting on an asset that's likely wasting," says Lawrence J. White, a professor of economics at New York University's Stern School of Business. "That's like idle capacity on a factory floor."

When builders cut their prices in one fell swoop, rather than letting them drift slowly downward, they in essence force sellers of existing homes to do the same. At the very least, that can be a severe psychological blow that in earlier slumps was absorbed over a period of time rather than all at once. For some homeowners, it's a catastrophic financial blow as well. With new, clearly established market prices, troubled homeowners who paid peak prices will have a harder time refinancing. Others, who need to sell fast, will most likely do so at a steep loss. If they sell for less than their mortgage, they'll be left owing money to the bank. And speculators who banked on being able to flip properties fast in a rising market or strapped homeowners struggling with adjustable-rate mortgages that are now resetting with higher payments face their own particular hell. As painful as such situations are, however, the excesses must be wrung out of the market before the sector or the broader economy can recover. "It's unfortunately a necessary part of the process," says Richard J. DeKaser, chief economist for Cleveland lender National City Corp. (NCC) "Once you see developers acting as aggressively as they are, the rest of the housing market is not too far behind."

Homeowners are almost always slower than builders to bite the bullet and cut their asking prices. That's why prices on sales for existing homes haven't dropped as precipitously as prices for new homes. The average price for a new home in Las Vegas, for example, is down 10% from the previous year compared with 3.8% in the resale market. With owners unwilling to accept lower prices, there's a growing glut of unsold existing homes here and across the country. On Sept. 25, the number of existing homes for sale nationwide, including vacant and owner-occupied listings, hit a 19-year peak of 4.58 million, up from 2.15 million in January, 2005, according to the National Association of Realtors. The resale market will eventually have to realign--meaning homeowners will have to cut their prices--before the slump can end.

BUILDERS' PARADISE

Driving along interstate 215 west of McCarran International Airport, it's easy to forget that Vegas' lifeblood is gambling and not homebuilding. Acres of brand-new subdivisions stretch for miles toward the red rock mountains in the distance. Out here, the brightly colored billboards on the highway aren't hyping entertainers on the Strip but rather new communities with aspirational names like Canyon Estates and Inspirada. A string of low-rise office buildings read like a who's who of the housing boom, with signs for Pulte Homes (PHM), Countrywide Home Loans (CFC), and Prudential Americana Realtors. Welcome to Constructionland.

A strong job market, the thriving casino and convention industry, and the highest population growth in the country made Vegas a boomtown for builders. Sin City represented one of the top five markets. Industry researcher Steve Bottfeld of Marketing Solutions estimates there are roughly 568 subdivisions being developed and marketed, the highest per capita in the nation. As recently as two years ago, prospective buyers would camp outside new developments to bid on dirt lots. Today, new homes are empty and communities half-built. The number of unsold homes has reached as much as 48,000, by some estimates, up from a more or less steady level of 10,000 over the last several years. "Builders have a glut of houses that's going to weigh on home prices for awhile." says Dennis L. Smith, president of Home Builders Research Inc., a local consultancy.

Mike Alley has gotten whacked hard by the area's declining housing market. In the spring of 2005, Alley, an independent real estate agent in Racine, Wis., moved to Las Vegas, lured by the warm weather and the strong real estate market. He quickly found a sales job with Pulte, where he says agents were pulling in $500,000 a year for basically taking orders. "It was nutty," says Alley. "Houses were flying off the lot."

A year later, he decided to jump into the market himself and buy a home. He spent a month searching, settling on KB's Huntington subdivision. The neighborhood attracted a mix of folks, from couples just starting out to empty nesters. More important, there were a lot of families with young kids the same age as his. The $86,000 worth of upgrades, including higher-end cabinets and granite countertops, thrown in by KB Homes at a discount clinched it. Alley thought he was getting a deal: In August, 2006, he paid $360,000 for a three-bedroom home in Quayside Court, which was appraised for $415,000.

Yet even Alley, who made his living in this industry, says he was blindsided by the markdowns. Today he reckons his home is worth around $300,000. "I didn't quite keep my finger on the pulse of what [KB is] doing in this community," says Alley, who's largely gotten out of the real estate business. "I'm looking at the sales data, and they were selling my model for $50,000 less even months after I bought it."

HOUSING SUMMIT

For Valentina Decarlo, who lives down the block, the situation is even worse. A longtime Las Vegas resident, the 39-year-old has spent almost 20 years working as a cocktail waitress, currently at Wynn Casino where tips supplement her $32,000-a-year paycheck. She took a gamble of her own last July when she put down $77,000 on a four-bedroom house.

After DeCarlo got stomach cancer last October, though, she missed work and started relying on credit cards to stay afloat. She's struggling to keep up with her $2,140 monthly payment. While she paid $367,500 in July, 2006, DeCarlo thinks similar properties are now going for less than $300,000. That means her home may not be worth more than her outstanding mortgage, so she can't easily refinance. Her lender, Countrywide, suggested selling the home at a loss or finding roommates, she says. "I'm going to lose everything that I've worked so hard for," says DeCarlo. "Our primary objective is to keep people in their homes," says Jumana Bauwens, a Countrywide spokeswoman, who adds the lender has completed more than 35,000 workouts on troubled mortgages in 2007.

If DeCarlo can't find a solution, she will face foreclosure, an increasingly common occurrence in this rapidly deteriorating market. Foreclosures in Las Vegas are the highest in the nation. And there's no sign of a slowdown: New filings in the city topped 33,000 through August, vs. 19,909 in all of 2006, according to the data firm RealtyTrac. The fallout in Las Vegas has been so bad already that Nevada Governor Jim Gibbons has called for a housing summit on Oct. 4 with the city's five largest builders, five largest banks, and others like Freddie Mac (FRE) and Fannie Mae (FNM) to figure out how to help troubled home?owners. "We are trying to target those folks who are headed downstream toward the waterfall before they get into trouble," says Lon A. DeWeese, chief financial officer of the Nevada Housing Div.

Speculators, especially those who bought late in the cycle, are likely to get hit the hardest. Roxasita Yasul, a 66-year-old retired hospital assistant, decided in late 2005 to supplement her Social Security and her husband's pension by investing in real estate. Back in the 1980s in California, she had tried her luck picking up houses at auction. It was a pretty successful venture. So she got her real estate license and bought four houses last year in new Vegas communities, including one in Huntington. Like most investors, a group who's rapid-fire buying and selling helped fuel the boom in this area, she figured she could always sell the properties in a rising market.

It hasn't worked out that way. Yasul paid $350,000 for the two-story home on Quayside Court in June of last year, but she expects it wouldn't bring in more than $300,000 today--if she could even find a buyer. She's not interested in selling now, hoping to wait for the market to rebound. "I'm not lucky with this one," says Yasul. "Those easy rates and interest-only loans will come due, and people will get hit with reality. The outlook is very gloomy."

In the meantime, Yasul is desperately searching for tenants. That causes its own problems. Too many renters in a neighborhood can further depress prices, a worry that's already causing consternation among her neighbors. "It's like living in an apartment community," says Elder, her Huntington neighbor. "Renters don't care as much about the homes if they don't own them."

The current housing downturn and the damage it's inflicting on the overall economy are far from over. With a slew of risky, adjustable-rate mortgages still to reset next year, foreclosure rates could climb even higher. That's a big reason why the stocks of the nation's 20 largest homebuilders have fallen an average 65% since the start of 2007. But there a few weak rays of light at the end of the tunnel. Builders are taking the painful step of cutting production. Permits are down 49% from the market's September, 2005, peak. That's half the time it took to reach this point in the last decline. "Builders definitely responded more quickly this time, and that's a good thing," says Banc of America Securities analyst Daniel Oppenheim. "But the inventory overhang is so great, it's going to take a long time to work through this. They still have a ways to go before there's a recovery."

Der Hovanesian is Banking editor for BusinessWeek and Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau